What it is — short definition
– The acid-test ratio, also called the quick ratio, is a liquidity metric that shows whether a company has enough near-cash resources to meet its short-term obligations (debts and payables due within one year). It is a stricter test than the current ratio because it excludes assets that may take longer to convert to cash.
Formula (clear and verified)
Acid-test ratio = (Cash + Marketable securities + Accounts receivable) / Current liabilities
Alternate numerator: Some analysts compute the quick assets as total current assets minus illiquid items (most importantly inventory), and also remove prepayments, advances, or other items that cannot readily cover liabilities.
Component definitions
– Cash: currency and bank balances, plus cash equivalents.
– Marketable securities: short-term investments readily convertible to cash at low cost.
– Accounts receivable (A/R): amounts owed by customers expected to be collected quickly; suitability depends on industry collection norms.
– Current liabilities: obligations due within 12 months (short-term debt, payables, accrued expenses, etc.).
How to compute — step-by-step checklist
1. Pull the latest balance sheet.
2. Identify cash and cash equivalents. Add marketable securities.
3. Decide whether to include accounts receivable — include only if collection is normally fast in that industry.
4. Sum those items to get quick (liquid) assets.
5. Add up all current liabilities.
6. Divide quick assets by current liabilities.
7. Compare the result to industry peers and to 1.0 as a rough benchmark.
Interpreting the result
– Ratio ≥ 1.0: the company generally has enough liquid assets to cover short-term liabilities.
– Ratio < 1.0: the company may not be able to meet short-term obligations without selling inventory or raising cash; treat with caution.
– Very high ratio (e.g., much greater than 1): may indicate excess idle cash that could be reinvested, used to pay dividends, or otherwise deployed more efficiently.
Key limitations and caveats
– Timing mismatch: the ratio ignores when receivables are collected versus when payables are due. A company can look liquid on paper but still face short-term cash pressure.
– Industry effects: inventory-heavy businesses (retail, wholesale) often have low quick ratios because they rely on inventory turnover; this is not necessarily a sign of distress for those business models.
– Accounting choices: different analysts or data providers may include or exclude certain line items; verify definitions before comparing reported ratios.
– Slow-paying receivables (e.g., construction) can overstate liquidity if A/R is included without adjustment.
Worked numeric example
Suppose Company X has:
– Cash and cash equivalents = $50 million
– Marketable securities = $20 million
– Accounts receivable = $70 million
– Current liabilities = $100 million
Step 1: Quick assets = 50 + 20 + 70 = $140 million
Step 2: Acid-test ratio = 140 / 100 = 1.40
Interpretation: Company X has $1.40 of quick assets for every $1.00 of short-term liabilities, indicating a comfortable short-term liquidity position under the assumptions above. You should still check the collectibility of A/R and the timing of obligations.
Practical checklist before using the ratio
– Confirm the reporting date and that the balance sheet is recent.
– Check whether A/R is typical for the industry (collection periods).
– Note any large one-off items in current assets or liabilities.
– Compare with industry peers and with the company’s own historical ratios.
– Combine with cash flow and working-capital metrics for a fuller picture.
Brief origin note
– The term "acid-test" likely borrows from a historical method of testing metals with acid — the ratio is meant to be a strict test of liquidity.
Sources (for further reading)
– Investopedia — Acid-Test Ratio (Quick Ratio): https://www.investopedia.com/terms/a/acidtest.asp
– U.S. Securities and Exchange Commission (SEC) — Beginner’s Guide to Financial Statements: https://www.sec.gov/fast-answers/answers-what-is-financial-statement.html
– Financial Accounting Standards Board (FASB): https://www.fasb.org
– CFA Institute — Financial Analysis and Methods: https://www.cfainstitute.org
Educational disclaimer
This explainer is for educational purposes and does not constitute personalized investment advice or recommendations. Always perform your own research or consult a licensed financial professional before making investment or business decisions.